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The Main Uses of Production Possibility Curve

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The Main Uses of Production Possibility Curve!

Scarcity and Resource Allocation:

Production possibility frontier or curve is an important concept of modern economics. This concept is used to explain the various economic problems and theories. The basic economic problem of scarcity on which Robbins’ definition of economics is based, can be explained with the aid of production possibility curve.

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According to the problem of scarcity, because of the limited availabilities of the resources, all wants of the society for goods cannot be satisfied; if a society decides to allocate more resources to the production of one good, it has to withdraw resources from the production of another good, as has been seen above.

Given the amount of resources, the economy has to operate on the given production possibility curve. As has been brought out above, ‘when we increase the production of one commodity moving along the production possibility curve, we have to reduce the production of some other commodity.

If the given resources are being fully used and technology remains constant, an economy cannot increase the production of both the goods represented on the two axes. This illustrates the basic economic problem. Thus, the basic economic problem is that, in view of the scarcity of resources, at what point of the production possibility curve, the economy should produce so as to maximise social welfare.

Production Possibility Curve and Central Economic Problems:

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Another use of production possibility frontier is that with its aid we can explain the central problems of what, how and for whom to produce. Which goods should be produced and in what quantities, implies that on what point of the production possibility curve the economy should operate.

A glance at Figure 5.1 will reveal that if the economy is operating at point B on the production possibility curve AF, then one thousand metres of cloth and fourteen thousand quintals of wheat are being produced. If the economy oper­ates at point E on this curve, four thousand metres of cloth and five thousand quintals of wheat are being produced.

Thus, operating at different points of the production possibility curve implies different allocation of resources between the productions of two goods. At which point of the pro­duction possibility curve, a free market economy will operate depends upon the consumers’ demand for different goods. In other words, in a free market economy, how the resources would be allocated between the two goods on a given production possibility curve is determined by the demand of the consumers.

How the goods are to be produced implies which methods or techniques should be employed for the production of various goods. In. other words, what resource combination should be used for the production of goods so as to maximise the output or to minimise the cost.

A factor would be used for the production of a product for which it is more efficient. It is obvious that this is the problem of technical efficiency. If for producing goods such resource combinations as will minimise cost of production are not employed, the economy will be operating at a point below the given production possibility curve.

Thus, if in the production of various goods, efficient methods are not used or if the resources are not employed in their efficient uses, the economy will not be operating at a point on the production possibility curve, instead it will be operating at a point below the production possibility curve such as U in Figure 5.2. The working of the economy below the production possibility curve indicates that less than maximum possible production is being done which will lower the welfare and standard of living of the people. The loss of production is the result of inefficient use of the re­sources.

For whom to produce or how the national product is being distributed is not directly revealed by the production possibility curve. However, we can obtain some knowledge of the distribution of goods from the production possibility curve.

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If a production possibility curve is constructed in which necessaries are represented on the one axis and luxuries on the other, we can know from the actual position of the economy on this curve that how the national output is being distributed. Consider Figure 5.4 in which on the X -axis necessary goods and on the F-axis luxury goods have been measured.

If the economy is working at point R on the production possibility curve PP in this figure, the g economy would be producing relatively more of luxury goods such as refrigerators, televisions, motor cars, air conditioners and would be producing relatively less quantities of essential consumer goods, such as food-grains, cloth, edible oil, which indicates that distribution of national income is very much uneven and the richer sections of the society will be getting relatively more of luxury goods, whereas the poorer sections would be deprived of even the necessaries of life.

On the contrary, if the economy is operating at point S on the production possibility curve PP, then it implies that essential consumer goods will be produced relatively more and luxury goods will be produced relatively less by the economy. This indicates that the distribution of income and output in the society in this case will be relatively more equal.

What quantities of various goods will be produced in a free market economy i.e. how much of luxury goods and how much of necessaries would be produced, depends upon the pattern of demand of the consumers. In other words, pattern of production will correspond to the pattern of demand. But it should be remembered that the pattern of demand depends upon the distribution of income in a society. The more unequal is the distribution of income in the society, the greater the amount of luxury goods produced in it.

The Problem of Unemployment and Underemployment of Resources:

As we have studied above, the problem of unemployment and underemployment of resources can be illustrated and understood with the aid of the production possibility curve. When all resources are being fully used the economy will operate at a point on the production possibility curve.

But the economy will operate at a point on the production possibility curve if aggregate demand is large enough to buy the total output produced by the full employment of resources. If aggregate demand is somehow smaller, the economy will not be able to use its productive capacity fully, that is, it will not be able to utilise its resources fully, which will result in unemployment and underemployment of resources.

In case of unemployment and underemployment of resources, the economy will be working at a point below the production possibility curve (such as point U in Figure 5.2). In such a situation if aggregate demand for goods increases, the demand for resources and, therefore, their employment will rise and as a result unemployment and underemployment will disappear and national income will in­crease.

Thus, it follows that as a result of increase in aggregate demand the economy moves from a point below the production possibility curve to a point on the production possibility curve. Re­nowned economist J.M. Keynes, who attributed unemployment and underemployment to the lack of aggregate demand recommended construction of public works on a large scale by the Government financed by deficit financing so as to raise the aggregate demand which will help in utilisation of resources fully and therefore in solving the problem of unemployment and underemployment.

The Problem of Capital Formation and Economic Growth:

Another important use of the production possibility curve is that with it we can explain with it the problem of capital formation and economic growth. In order to explain the problem of capital formation we have to construct such a production possibility curve in which on one axis capital goods and on the other axis consumer goods are measured.

This has been done in Figure 5.5 in which along the X -axis consumer goods and along the Y-axis, capital goods are measured. If the economy is allocating the available resources between capital and consumer goods in such a way that it operates at point A on the production possibility curve PP, it will be producing OC1 of consumer goods and OK1 of capital goods. Now suppose that the society decides to produce more of capital goods.

To implement this decision society will have to withdraw some resources from the production of consumer goods and use them for the production of capital goods. As a result, the production of consumer goods will decline. It is clear from Figure 5.5, that if the economy reallocates its resources between consumer and capital goods and shifts from point A to point B on the production possibility curve PP, it will now produce OK2 of capital goods and OC2 of consumer goods.

That is K1K2 amount of capital goods will be produced more and C1C2 amount of consumer goods will be produced less than before. We, therefore, conclude that in order to step up the rate of capital formation the production of consumer goods and therefore consumption has to be reduced.

But the above conclusion is based on the assumption that the economy is using its resources fully and most efficiently and is operating at a point on the production possibility curve. However, if some available resources are lying unemployed and idle or the economy is not using them more efficiently, the economy will be working below the production possibility curve.

When the economy is working at a point below the production possibility curve, then more capital can be created with­out a reduction in the production of consumer goods because by employing idle and unemployed resources, economy can produce more of capital goods.

But, as has been explained above, if the economy is utilising its resources fully then the rate of capital formation cannot be increased without the reduction in consumption. But it is worth noting that when the rate of capital formation is raised, this does not mean that amount of consumption is reduced forever.

The accumulation of more capital enables economy to increase its production of consumer goods in the future. That is, the accumulation of capital raises the productive capacity of the economy. Thus, capital accumulation implies that “less jam today for more jam tomorrow.”

Since the accumulation of capital raises the productive capacity, national production will in­crease, that is, economic growth will take place. As a result, the economy will not remain on the same production possibility curve and its production possibility curve will shift outward which indicates that the economy will be able to produce more than before.

The greater the rate of capital formation, the greater the extent of shift in the production possibility curve, and the greater the rate of economic growth. Consider Figure 5.6 in which in the beginning the economy is producing OC1 of consumer goods and OK1 of capital goods on the production possibility curve P1P1.

If the economy maintains this rate of capital formation, then the production possibility curve will go on shifting and the economy will be growing annually at a certain fixed rate. It should be noted that in Figure 5.6, as a result of low rate of capital formation, production possibility curve shifts outward at a relatively slow speed. Thus growth path OR in Fig. 5.6 represents a lower rate of economic growth.

If the society wants to obtain a higher rate of economic growth, it will have to raise its rate of capital formation. This is shown in Fig. 5.7 in which the economy is producing at point t1 on the production possibility curve P1P1, with OK2 of capital goods at OC1 of consumer goods.

If the economy maintains this rate of capital formation, production possibility curve will go on shifting outward to a greater extent than in Figure 5.6. This means that the rate of economic growth will now be relatively greater than in Figure 5.6. In the two Figures 5.6 and 5.7, it will be noticed that, in the beginning in Fig. 5.7; the production of consumer goods is less than in Figure 5.6, but when as a result of higher rate of economic growth, production possibility curves reach their position P4P4 at time t4, it will be producing more consumer goods in Fig. 5.7 exhibiting higher rate of economic growth than in Figure 5.6, where the rate of capital formation and therefore the rate of economic growth is relatively less.

We have explained above economic growth which has been brought about by capital formation. Besides capital formation, there are other factors which determine rate of economic growth. Progress in technology and expansion in education also favorably affect rate of economic growth’ and cause production possibility curve to shift outward.

We have explained above only some important uses of production possibility curve. There are several other uses of production possibility curve. We can understand better the concept of opportu­nity cost with the aid of production possibility curve.

The concept of production possibility curve has also been extensively used in welfare economics and in the theory of international trade. In the modern economic theory gains from international trade have also been explained with the aid of production possibility curve.